What Mr. Bond is telling the market

There is no shortage of research out there trying to explain the big surprise of the year: the rally in bonds that has dragged the yield on the 10-year U.S. Treasury note down more than 50 basis points to 2.5%.

Most analysts have attempted to explain the yield decline from a fund-flow or market-positioning standpoint. Among the explanations: portfolio rebalancing after last year’s dramatic relative-return gap between stocks and bonds; People’s Bank of China buying to weaken the yuan; and forced buying by commercial banks as they rejig their new risk-weighted capital/asset ratios.

There is also talk in the markets that the European Central Bank (ECB) will ease by creating euros to buy U.S. Treasury securities (one sure way to weaken the currency).

All are valid, but still fall short of explaining the yield decline this year.

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The yield slide also has had nothing to do with lower inflation expectations. Many such measures have bottomed and hooked up while the two major inflation hedges in the stock market (energy and basic materials) have emerged as top S&P 500 sector performers so far this year (4.6% and 3.3%, respectively, versus 1.3% for the overall market).

Real interest rates have adjusted lower, which is hardly consistent with declining real growth. But the forward curve has undergone a massive adjustment as the market reprices the outlook for Fed policy. Even as the taper continues, the Fed funds rate will stay near 0% for longer and when it does go up, the central bank is determined to take its time in bringing the funds rate to its neutral level, however defined (most peg it between 3% and 4%).

New York Federal Reserve Bank president William Dudley hinted at this earlier this week. Ben Bernanke has also affirmed that the neutral or terminal Fed funds rate will not be achieved for many years, which is quite a statement from someone who a year ago threatened to start raising rates — never mind ceasing QE — once the unemployment rate dipped below 6.5%… it is now 20 basis points below that threshold.

It isn’t just the Fed, either: Bank of Canada Governor Stephen Poloz has hinted at a rate cut; in the U.K., Mark Carney has clearly stated that not even ripping growth and surging home prices will derail the Bank of England’s ultra-accommodative monetary policy; the ECB is about to become very aggressive; and the Bank of Japan seems set to further add to its balance sheet expansion strategy.

Global monetary policy, five years into the recovery, remains on steroids.

But back to the Fed. It was most interesting to see chairwomen Janet Yellen, at her first meeting without Mr. Bernanke at the table on March 19, make her first attempt at forward guidance by stating:

1. [T]he Committee currently anticipates that, even after employment and inflation are near-mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.

This was an addendum — an exclamation mark more like it — to:

2. [T]he Committee continues to anticipate … that it will likely be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends.

Item No. 1 tells us any future rate hikes will be extremely light and gradual, and item No. 2 indicates the fateful day of that initial volley is a heck of a long time away.

The entire yield decline has been a combination of reduced growth expectations and shifting views on the Fed policy outlook.

No wonder inflation expectations can’t play a role. Both Mr. Bernanke and Mr. Dudley have stated for the record and 24 hours apart that the 2% inflation objective is as much a floor as it is a ceiling. How do you like that? Not too much if you’re considering adding on more duration from these levels.

The Treasury market is not overbought and remains in good shape from a technical standpoint. And the yield upside has now been capped by the Fed’s verbal intervention to influence forward swap rates and dampen rate hike expectations.

But all of this obscures one point: The bond rally has little to do with economic fundamentals.

The Institute for Supply Management composite index is at a solid 55 reading. The National Federation of Independent Business small business optimism index is at seven-year high of 95.7. The smoothed Economic Cycle Research Institute leading index stands at a 10-month high of 4.9% growth.

Jobless claims are now below 300,000 for the first time since mid-2007 and we have just experienced three straight months of 200,000-plus payroll gains (the last time that happened in the last cycle was early 2006).

That bonds have continued to rally even after that plus 288,000 payroll print at the start of the month indicates this simply cannot be due to the economic backdrop.

Furthermore, the Dow Jones transportation index hit a new high at Monday’s close, so I cannot believe the bond market is telling us anything about growth. All the more so given that the Dow Jones utilities index is down 5% from its May 1 peak.

The Dow transportation-to-utilities ratio looks very strong and belies the notion that the bond rally is sending out a negative economic signal. Quite the contrary. Ditto for the platinum-to-gold price ratio, which also has a strong correlation historically with bond yields.

These are classic non-confirmations on this bond rally, or at least its perceived message.

The effective result is a de facto rate cut by the Fed since this yield move would not have been possible without its new forward guidance on the future policy path.

It’s akin to an exogenous positive shock to the economy, especially the rate-sensitive sectors (housing, autos, capital goods). It’s as if the Fed eased 50 basis points via the back end of the yield curve, just as Mr. Poloz managed to accomplish a de facto 300-basis-point easing in Canada via the weaker exchange rate.

This is the message from the Dow Jones transportation index: This bond yield decline, contrary to reflecting a softer pace of economic activity ahead, is more than likely going to bolster the macroeconomic outlook for the spring and summer months.

Look through this corrective phase in equities and look forward to picking up cyclical and growth segments at better prices. The Dow transportation index may have this story more right than the bearish growth stories emanating from some vocal commentators from bond-land.

David Rosenberg is chief economist and strategist at Gluskin Sheff + Associates Inc. and author of the daily economic report, Breakfast with Dave. Follow David and his colleagues on Twitter @GluskinSheffInc

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